Credit markets are being transformed at a phenomenal pace with transacted notional amounts in credit derivatives reaching new heights every year. The British Bankers' Associates has estimated the size of this market to be currently around $24.0 trillion. Credit default swap indices have brought a level of standardization to the securities they comprise. This facilitates analysis that relates credit spreads to observable information in equity markets, which offer a transparent and liquid source of information.
The link between equity markets and credit spreads is well developed under many structural models. Numerous models have been developed, including those described in: Robert C. Merton, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, 29:449-470 (1974); Fischer Black and John C. Cox, Valuing Corporate Securities: Some Effects of Bond Indenture Provisions, Journal of Finance, 31:351-367 (1976); Hayne E. Leland, Corporate Debt Value, Bond Covenants, and Optimal Capital Structure, Journal of Finance, 49(4):1213-1252 (1994); and others. However, empirical studies such as Young Ho Eom, Jean Helwege and Jingzhi Huang, Structural Models of Corporate Bond Pricing: An Empirical Analysis, Review of Financial Studies, 17:499-544 (2004) conclude that a significant mismatch between the model and the market remains.
An important metric often associated with many of the structural models is distance to default, which is the volatility normalized difference between a firm's value and its liabilities. Distance to default is a coarse measure of creditworthiness and is often widely used to rank firms and forecast credit events. However, distance to default alone does not explain credit default swap spreads. Many structural models may be misaligned due to the fact that they are often driven by a single factor.